General liquidity ratio or total liquidity ratio - this is the ratio of current assets of the company to its short-term liabilities. Thus, it is possible to determine how much current assets of the organization are able to cover any Short-term liabilities.
Why is it needed?
The higher the overall liquidity indicator, the more confidence there will be that it will be able to repay all of the company's obligations at the expense of those assets that are available to it.
It is quite difficult to justify the acceptable indicator. Of course, the general indicator of liquidity will vary depending on the specific field of activity of the enterprise. In particular, it is worth noting that due to various reasons, including the significant proportion of all kinds of hard-to-sell assets, as well as the duration of the operating cycle of various construction or industrial enterprises, it is necessary to provide a higher coefficient compared to the value that is acceptable for enterprises operating in the areas of supply, trade and marketing.
What should it be like?
It is believed that when the overall liquidity ratio of a company is below 2: 1, then in this case it does not have the ability to fully repay all obligations it has on time.
A significant excess of assets over liabilities (which is an extremely rare situation for domestic enterprises) suggests that the company has a fairly large number of free resources that it generates from its sources. Lenders consider such a formation own working capital most relevant. Speaking from the point of view of the performance of a particular enterprise, a significant accumulation of reserves, as well as additional diversion of funds into accounts receivable, is often due to the fact that the company has inept asset management.
What does it affect?
The general liquidity indicator, the calculation formula of which can be used at any time periods, has a somewhat exaggerated influence on the assessment of a company's ability to meet its obligations, and especially not the most optimal decision to use it as the main criterion for a potential bankruptcy of the company (other characteristics are its derivatives). Of course, today this ratio is used most often. But the main advantage that a common liquidity indicator (formula) has is the ease of calculation, and not some kind of universality or comprehensiveness, which they often try to attribute to it.
Which value is optimal?
The practice of domestic and foreign companies showed that if a company has a coefficient value of more than two, then for industrial enterprises this is more likely an exception to the rule, because there are many reasons from which it is worth highlighting the main one for domestic companies - this is a lack of equity, as well as the need in the direction of the resulting net profit directly to the needs of consumption.
disadvantages
The general indicator of balance sheet liquidity (formula) has several disadvantages, namely:
- Static The obtained indicators are calculated based on the balance sheet data, which show the property status of the company according to its condition at a certain date, as a result of which they are simultaneous.In this regard, a detailed analysis of their dynamics at different time periods is required.
- The possibility of overstating. In this regard, all sorts of “dead” items, such as illiquid stocks of various inventories, may be included in the composition of assets.
- Low information content. If a general balance sheet liquidity indicator (formula) is used, it is rather difficult to predict any future payments or cash receipts, which is the main task of analyzing the company's current solvency.
- The possibility of overstatement due to accounts receivable, which is illiquid. Since recently the lack of payments has become mass, while a significant part of receivables is overdue, and a certain part of it is that debt that is unlikely to be collected or will not be paid at all, we can say that in fact, customer debt increased in the current balance precisely because of too low payment discipline, and not because the business activity of the company increased.
How to analyze?
Initially, you need to carefully evaluate the composition, as well as the timing of the formation of the debt, and then find out if several types of debt, in which there are significant differences in the timing of occurrence, were combined in one article. Already after taking into account this, the value of the actual receivables will be adjusted, it will be possible to calculate in detail the coefficient (general liquidity indicator). For this reason, the International Financial Reporting Standards, as well as those adopted by the Ministry of Finance of Russia, indicate that it is necessary to fully disclose the full amount of financial obligations in a separate explanatory note.
The reflection of assets in the balance sheet is carried out in the predominant majority of cases at their initial cost, that is, directly in the amount of money that was accrued or paid in the process of purchasing or producing a certain product. During inflation, keeping records of assets in accordance with actual cost may ultimately lead to discrepancies between the market and book values of the property.
Stock Valuation
The requirement of increased caution introduced in domestic practice regarding the valuation of stocks, as well as their mandatory revaluation at the end of the year, if the market value is less than the book value, does not allow in this case to solve the problem, because in modern market conditions of inflation, the cost of stocks is an order of magnitude higher compared with their cost. For this reason, information about the current assets of the company is distorted and the liquidity ratio is underestimated.
That is why, when determining the overall indicator of balance sheet liquidity, it is extremely important to comply with PBU 5/98 instructions regarding the mandatory provision of information on what current market value of stocks in the notes to the statements, regardless of whether this estimate is lower or higher than the balance sheet.
What to consider?
It is worth noting that any recommended indicator values should always be considered carefully and take into account both the scope of your company and the characteristics of the turnover of available capital. Thus, under certain conditions, the ratio of the duration of the ongoing operating cycle, as well as the maturity of the payables present, the value of this indicator may be an order of magnitude lower than anticipated, that is, the need to use its own working capital is an order of magnitude smaller than half of current assets.A similar situation is quite common in the practice of trading enterprises, while a general indicator of the liquidity of a construction or industrial type enterprise is rarely encountered.
Thus, if we mechanically compare the value of assets and liabilities, not taking into account the features of production activities, as well as various individual components of current assets and liabilities, in the end, we can distort the reliability of the assessment of the financial condition of a company. For this reason, the general indicator of the liquidity of the balance sheet of an enterprise must be taken into account solely from the point of view of an analysis of its dynamics.
Where is it used?
In this regard, we can conclude that the scope and analytical capabilities that the liquidity ratio has are much higher than conventional wisdom. An in-depth analysis of the solvency of the company involves the use of a number of additional tools with which you can maximize the results of the analysis. It is worth noting that the most important issues that will need to be clarified in the process of conducting such an analysis are:
- Quality composition current liabilities and current assets.
- The turnover rate of the assets present, as well as the degree of its correspondence to the turnover rate of all liabilities.
- Features of accounting policies for valuation of liabilities and assets.
Thus, the general liquidity indicator shows only basic information about the state of the enterprise, and for a full assessment of its solvency it is necessary to conduct a much more detailed study.
Formula
The liquidity ratio is calculated by the following formula:
TOOl = (A1 + 0.5A2 + 0.3A3) / (P1 + 0.5P2 + 0.3P3)
In the process of liquidity analysis, the value of this ratio should be more than 1, since otherwise the company is forecasting potential bankruptcy.
